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Temporary Reprieve for Inefficient Firms in China

Following our “global reflation” forecast call last year, Chinese import and export prices climbed to their highest readings in five years, after staying in negative territory for about four years. Meanwhile, China’s domestic reflation was partly driven by a revival in the manufacturing sector that began earlier this year, as anticipated by our Chinese Leading Industrial Production Index (CNLIPI). Since producer price inflation is related to industrial production growth, CNLIPI growth also tends to anticipate cyclical turning points in the growth rate of the producer price index (PPI).

Indeed, after year-over-year (yoy) CNLIPI growth entered a cyclical upturn in early 2015 (not shown), a sharp cyclical upswing in yoy PPI growth (chart) followed later that year. By the time PPI growth started to turn up, it had been in negative territory for over four years; nine months later, it turned positive, and by February 2017 it had risen to a nearly 8½-year high, before slipping a bit.

As we wrote in early 2015, the extended period of negative PPI growth was reflecting massive and persistent overcapacity. That overcapacity was particularly egregious higher up in the supply chain, especially in state-owned enterprises (SOEs) that were involved in the extraction and production of raw materials. Since SOEs are typically used by the provincial governments to achieve goals set by the central government and have easy access to credit, they are often run inefficiently, with little emphasis on the bottom line. It is therefore no surprise that they built up massive inventories that were out of sync with future demand.

Consequently, the inefficiencies of SOEs, which had previously been covered up by high prices, became blatantly obvious. Suddenly, these companies were making losses and struggling to repay their debts, while China’s rust belt provinces, which rely on heavy industry, were falling behind the rest of the country.

In this context, the latest cyclical surge in producer prices must have been like a shot of naloxone, bringing some near-death companies back to life, and on the back of higher prices industrial companies’ profits grew at their fastest pace in nearly six years. However, while the government has pledged that it will close inefficient and heavily-polluting mines and plants, it is not entirely clear how much overcapacity remains in the system.

In that sense, if PPI growth, which remains below its earlier high, is beginning to roll over, it could expose whether the resurrections are for real. The latest update to the CNLIPI clarifies whether or not PPI growth has already peaked, or if cyclical forces are still favorable – with implications not only for China, but also for inflation prospects globally.